Mastering the political business cycle

Summer rate rise could be less controversial than later

by George Hoguet

Fri 10 Jun 2016

The Federal Reserve’s monetary policy reaction function will remain data-dependent for the remainder of 2016, but the US presidential race may bring forward the timing of the next increase in the federal funds rate.

At the margin, it is easier for the Fed to raise rates in the summer, rather than September or November, when the presidential election campaign will be in full swing.

The Fed must garner support from four primary constituencies: Congress, ‘Main Street’, Wall Street, and the executive branch of government. To these must be added several others – disenfranchised groups seeking access to cheap credit, populists suspicious of large banks, and other vocal interest groups.

The Fed must be especially attentive in a presidential election year to avoid alienating the prospective chief executive, one of whose principal powers is the power of appointment. And, as a creature of Congress, it must closely follow developments on Capitol Hill.

Since the Fed’s creation in 1913, Congress has amended the original legislation – or otherwise modified the Fed’s breadth of control – several times. For example, the Dodd-Frank Act of 2010 reduced its discretionary emergency lending powers (widely used during the global financial crisis) under Section 13(3) of the Federal Reserve Act.

In terms of the presidential campaign, the Fed’s critics still accuse former Fed chair Arthur Burns of running an overly lax monetary policy in 1972 to facilitate Richard Nixon’s re-election.

Since the 1970s, a rich academic literature has developed on the ‘political business cycle’. Proponents suggest that the cycle results from politicians manipulating policy tools to stimulate the economy just prior to an election in the hope of improving their own party’s re-election prospects.

In their view, economic booms and busts can result from over-stimulus in an election year, with the resulting inflation leading to retrenchment after the election.

The Federal Open Market Committee will meet four times before the 8 November elections: on 14-15 June, 26-27 July, 20-21 September, and 1-2 November.

Both the Republicans and Democrats will hold their conventions in July, early by historic standards. The July FOMC meeting coincides with the Democratic convention and comes a few days after the Republican convention.

Coming into the conventions and the general election cycle, the Fed is below its inflation target and faces an improving labour market but weak output growth. The economic data appear to be giving mixed signals; market expectations of a further rate hike in 2016 are well below the most recent ‘dot plot’.

Should the data improve in the coming weeks, raising rates in June or July may be less controversial than doing so in September or November.

While low interest rates since the global financial crisis have penalised savers, interest rate cuts from a political standpoint generally remain more popular than interest rate increases.

The candidates would be sure to comment on a hike in September or November, with some arguing that a rise is a sign of an improving economy and others that Fed action was premature. Savers and the banks would like to see rates rise, while other constituencies are less enthusiastic.

Given the sell-off in global stock markets following the Fed’s interest rate ‘lift-off’ in December and recent conflicting signals, the Fed must be particularly astute in the timing of its next hike.

The presidential election is a further complicating factor in FOMC decision-making. But it will not be an explicit policy variable, or a principal determinant of policy.

George Hoguet retired on 1 June as Global Investment Strategist in the Investment Solutions group of State Street Global Advisors, and is a Member of the OMFIF Advisory Board.